Will there be student loan forgiveness in 2023? Important specifics
For more than a year, everyone has been talking about student loan forgiveness: the Biden administration has introduced multiple student debt forgiveness schemes, including one-time or limited forgiveness, expansion of current student loan forgiveness, and extension of existing forgiveness programs.
The restricted PSLF waiver alone has resulted in the forgiveness of nearly $24 billion in student debt.
However, as tax season approaches, the student debt forgiveness tax situation becomes more complicated than ever. Here's what borrowers should be aware of.
Background: Student loan forgiveness may be taxed.
When debts of any sort (including student loans) are forgiven, reduced, or cancelled, the borrower may face tax repercussions. The lender issues the borrower a Form 1099-C, which is a tax form that shows the amount of debt forgiven or cancelled. The form is provided during the prior tax year in which the discharge happened. If you pay off a loan in 2022, you could get a Form 1099-C in early 2023.
The paperwork, which is also forwarded to federal and state tax authorities, instructs the borrower to declare the discharged debt as "income" on their tax return. This might lead to an increase in income tax.
Certain tax breaks for debt forgiveness are still available under federal law. In rare situations, the debtor may argue that the debt is invalid or contestable. If the borrower's entire debt exceeds his or her total assets at the time of discharge, the borrower may be able to establish incapacity to pay, which may decrease or eliminate the resultant tax penalty.
However, whereas ordinary debt forgiveness results in the issuing of a Form 1099-C and may be taxed, student loan forgiveness is more problematic, particularly now.
For the time being, federal loan forgiveness is tax-free.
Under federal law, federal student debt forgiveness, cancellation, and discharge are temporarily tax-free. The American Recovery and Reinvestment Act of 2021 exempted student debt forgiveness from federal taxation until the end of 2025. This includes government loan forgiveness under the following programs:
- PSLF (Public Service Loan Forgiveness), which includes limited PSLF forgiveness.
- Dependent Income Reimbursement (DIR), includes account adjustments.
- Total and Permanent Disability (TPD) retirement.
- Defending repayment for borrowers who have been duped by their colleges.
President Biden has previously proposed for student loan debt forgiveness of up to $20,000. Due to legal difficulties, this initiative is now on hold, but the Supreme Court is likely to rule this summer.
The American Bailout Act of 2021 exempts student loans from federal income tax, but not from state income tax. Many states have debt forgiveness laws or policies that mimic the federal tax treatment, although this is not always the case. In rare situations, even though the borrower is not federally taxed, the borrower may be forced to pay state income tax as a result of student loan forgiveness.
Some federal student loans may be subject to taxation in the future.
Although federal student loan forgiveness is now tax-free, it is just a temporary remedy under the conditions of the American Bailout Act of 2021. Unless Congress extends or makes permanent these provisions through new legislation, the tax exemption will expire at the end of 2025.
Following then, the federal tax status of the student loan exception will revert to what it was previous to passage. Previously, under federal law, forgiveness of employment-based student loans, such as PSLF, was not taxable.
Furthermore, the IRS has said that loan forgiveness provided under the Borrower Defense to Repayment program would not be taxed under federal law. Loan forgiveness via the Income-Driven Repayment (IDR) schemes, on the other hand, will be taxed beginning in 2026.
Under a different tax law established by Congress in 2017, forgiveness under the PDT forgiveness program for borrowers with disabilities is not taxable. Even so, it will expire at the end of 2025. If Congress does not renew the exemption, PDT discharges may be subject to federal taxation beginning in 2026.
Private student debt cancellation and amnesty may be subject to taxation.
Private student loans are ineligible for federal student debt forgiveness schemes such as PSLF, IDR, or Borrower Defense for Repayment. Private student debts, on the other hand, may be forgiven in certain circumstances, such as the borrower's infirmity or death. Furthermore, delayed private student loans may be repaid for less than the full amount outstanding, resulting in partial forgiveness.
Private student debt forgiveness may be subject to taxes. The American Recovery and Reinvestment Act of 2021 includes a tax relief provision that applies to "all private school loans (as defined in section 140(a)(7) of the Truth in Lending Act)" until 2025.
It is unclear, however, whether this clause applies to all private student loans or to all circumstances of private student debt forgiveness or reduction, such as a negotiated settlement. Furthermore, the IRS has not offered clear instructions.
Borrowers should seek the advice of a skilled tax professional.
Because student loan forgiveness and federal and state regulations intersect, borrowers who have obtained (or plan to receive) student loan forgiveness, cancellation, or reduction in 2022 should consult a knowledgeable tax expert, such as an accountant or tax attorney. Borrowers must understand their legal rights and duties in order to prevent expensive mistakes on tax returns.